The Power of Passive Index Fund Investing: An Example

The other day, I was trying to explain to a friend why I invest in index funds. I came up with this example, which I’m not sure is perfect but I thought I’d share it.

Background: Market Cap Indexes
When you hear “index funds”, it traditionally means mutual funds that follow an index which holds companies proportionally to their market capitalization. If a company has 1,000,000 shares and each share is trading at $25, then its total market capitalization is $25 million.

Let’s take the S&P 500 Index. The market cap of Starbucks (SBUX) is $14 billion dollars, while Exxon Mobil (XOM) is worth $334 billion. So an index fund tracking the S&P 500 would hold 24 times as much Exxon as Starbucks.

The index fund is “passively managed” in that it does not make any of its own decisions on the value of each company, it simply accepts the value of the each company as determined by each day’s market trading between millions of investors.

An Alternate Universe

Let’s imagine an alternate universe where we only have two companies, AAA and ZZZ, that make widgets, the one thing people there buy. Both have a million shares outstanding. Company AAA makes widgets and has earnings of $1 million a year. It’s been around a while and is fairly boring, so the price/earnings ratio is 10, making the market cap $10 million. Thus, each share is worth $10.

Company ZZZ also makes widgets and has earning of only $500,000 per year. But it’s newer and makes stylish widgets that attract young people. People seem to think it has greater potential for earnings growth, so the P/E ratio is 20. Thus, the market share is also $10 million, or $10 per share.

An index fund is created to track this alternate universe, and based on market-cap it holds 50% AAA and 50% ZZZ.

So what happens in the future?

Scenario #1
ZZZ could keep taking market share from AAA with their cool and stylish widgets. AAA’s earnings go down to $500,000, and the P/E stays constant at 10, leading to a new market cap of $5m. ZZZ starts earning $1,000,000 per year, and with a P/E of 20 grows to a market cap of $20m.

What happens to the shares in your index fund? Nothing. No trades are made, because only the share values have changed. You hold the same number of shares of each. However, your fund’s value has grown 25% because the value of ZZZ has doubled, while the value of AAA has been cut in half. Your holdings based on market value are now 20% AAA and 80% ZZZ.

Scenario #2
Things are going along, but then a new medical study finds that ZZZ’s widgets cause cancer, and it turns out the CEOs have been covering this up for years. ZZZ tanks, and is now trading at a penny per share, while everyone is switching to AAA’s reliable widgets. AAA goes up to a market cap of $25m ($25 per share).

What happens to the shares in your index fund? Still nothing, even though you now own 99.96% AAA. Meanwhile, your fund has grown another 20% because of AAA’s growth, even with ZZZ’s collapse.

Summary
You don’t know what is going to happen in the future. There are a million different possible scenarios I could have chosen. AAA could have split off a small division called BBB and it could have taken over the world. The most important point is, whatever happens, with a market-cap index fund, you are guaranteed to own all the winners.

You’ll also have owned the losers, but remember you won’t know who they are beforehand. Buggy whip manufacturers used to be huge. Now, iPhone-making companies are growing. One day iPhones will be in landfills, and we’ll be onto downloading knowledge directly into our brains or something. Or maybe we’ll run out of oil and be back to buggy whips. Who knows.

“Don’t look for the needle in the haystack. Just buy the haystack.” – John C. Bogle

This is the power of passively-managed index funds. With low-cost index funds, you’ll even be guaranteed to beat the average investors’ performance because of investment expenses eating into their return.

In scenario 1, wouldn’t ZZZ taking market share from AAA already have been taken into account with its higher P/E? Presumably, if it has a higher P/E, it is because people expect it to grow, and if it has a competitor then its growth would certainly be expected to affect the competitor. So, the very fact that ZZZ doubles in “earnings” doesn’t mean its stock price goes up. The earnings double was already “priced in” with the higher P/E. It would only go up if people anticipated that it would further increase its earnings into the future beyond what it has already increased. Otherwise, its P/E would drop. Even if it dropped to 15 because further growtn wasn’t possible, the shares in your index fund wouldn’t be worth more. Imagine:

AAA P/E 10 -> MC 5m
ZZZ P/E 15 -> MC 15m

Your shares in the fund are worth the same. But, this is far from the only possible outcome… what if for ZZZ to take share from AAA, its profitability declines per dollar of revenue? Both AAA and ZZZ could have profitability decline, decreasing the value of *both* companies on the basis of market cap. Needless to say, this scenario is much too simplified to be argued that owning the “winners” and “losers” at the same time is always of benefit.

This is a good example. I think what is also important in this example is that you only had to make one decision – to buy the market as opposed to individual stocks. Although I do personally own individual dividend stocks, it is only because I enjoy the analysis and dividend growth model. I own a core portfolio of index funds because of the the reasons you elaborated on.

Another way to describe a benefit of index funds is to separate the investing world to only two types of investors: Active or Passive. A passive investor will just hold the market (represented by an index fund). They do not try to beat the market, rather they just try to “be” the market.

The other investor will try to outperform the market by taking an active bet against it. He/She will be overweight some stocks, or underweight others, etc.

The funny thing about the market overall, is that it is the sum total of all the active investors’ decisions put together.

Since the cost of passively tracking the market is low (through index funds with no thought), and the cost of actively managing a portfolio is higher then it is a mathematical truth that the passive investor MUST beat the aggregate actively invested dollar.

Remember, the performance of the passive investor before fees mirrors the market. The performance of all the active investors together IS the market. This does not preclude an active investor from beating the market. Some will, some will lose.

Nobel Prize winner William Sharpe proved this mathematically years ago.

@Brian – You might think, but there are some mysterious things out there. Did you know that Apple is currently worth almost as much as GE?

Apple P/E ratio 30 Market Cap 147.56B

GE P/E ratio 10, Market Cap 154.83B

Two different companies, but the growth expectations of AAPL are still huge. I’m sure plenty of analysts have come up with a story for why, and maybe they’ll be right. If you put a gun to my head and made me choose, I’d definitely take GE. But with index funds, I won’t have to worry about it. If AAPL takes over the computing world… I’ll own it.

While I don’t disagree with notion of index funds and passive investing, I think this example also expose the danger of index funds. In this case, it’s all about the starting point. Had you purchased in scenario #1, and proceeded to scenario #2, you would’ve been wiped out. The problem with index funds is that they DO weigh what is most popular at that time. Nothing wrong with that, but to imply that’s completely riskless is not accurate. Just asked people who invested in 2000 when the indexes were heavily overweight dot.coms….

@ Preet – you hit the nail on the head. Even if an investor or money manager beats the market one year, the probability that he or she does it every year is slim. Just look at Bill Miller. After 15 years of topping the S&P 500, he lost three years in a row (2006-2008) and by substantial sums. Investors would have been better off in an index fund than his fund. In the end all investors tend to mean revert, except for maybe Warren Buffett.

Passive investing is certainly not riskless, as in this case you’re still investing in equities and an unknown stream of future income. But in comparison with active investing and/or buying individual companies, I think the risk is definitely reduced both in the short run and long run.

Jonathan,
Is it possible to do a post on how to systematically invest in index funds? Since most of us are salaried and afford a lump sum investment; how do you channel it all among differnt index funds while maintaining your asset allocation.

With vanguard you can have as little as $50 go into any fund account in any time frame. So, you can completely setup some crazy investment patterns making regular contributions. It’s really straight forward on the website.

Index funds seem to be quite a good investment option, though they don’t give you whooping returns, over a period of time they grow steadily to give you good returns. There are some merits like, You get the cream of mutual funds, Don’t have to keep a track of individual stocks, Indexed funds are better performers than active funds, like this there are some demerits also such as, it is expensive stocks, Stocks only from within index range.

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